Tuesday, 18 June 2013

Where to next for central banks?

Saving the global
economy might have been the easy bit – now central banks have to find a way to
get out of the limelight.

The outlook for the world economy is far from sunny but talk
of impending doom regarding the fiscal cliff in the US or the collapse of the
Eurozone seems to have passed. Central
banks have been called on like never before to save us from economic
catastrophe and have developed new strategies to deal with the unique problems
thrown up by the global financial crisis.
But the deeper the central banks get involved, the more difficult it
will be for them to extract themselves from their new dominant roles in
propping up the global economy. Signs of
economic recovery mean that this tricky task is at hand but the way out will
not be easy.

The first to have to come up with an exit strategy is the
Federal Reserve in the US due to a relatively robust economy with the US
economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for
2014. The third round of quantitative
easing means that the Federal Reserve is currently purchasing bonds worth US$85
billion each month with a promise to continue this until there is substantial
improvement in the labour market. With
the unemployment rate having edged downward from 8.1% in August to 7.6% in
June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of
tapering off its bond buying which will be the beginning of the a long process
of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central
banks becoming considerable buyers in the bond market but also interest rates
being set at record lows. It is fair to
assume that these policies have helped ease the pain stemming from the global
financial crisis, if not having staved off economic meltdown. Yet, the flipside of the dominant role taken
by the central banks is that the reversing of these policies brings its own
problems. Central banks have typically
been supported for their actions in the face of possible disaster especially
considering the squabbling of politicians. While
policies that boost the economy during slowdowns will always be welcomed, measures
that add headwinds to an economic recovery (tightening of monetary policy) are
unlikely to make central banks popular.
Yet, the bond buying and record low interest rates distort the economy
and may create problems in the future.

So a return to normality in terms of monetary policy is
inevitable but it will be a protracted process with purchases of bonds by
central banks being pared back followed by interest rates being nudged upwards
all depending on the state of the economic recovery. This chain of events may start this year in
the US, maybe in the summer but probably later in the year or in early 2014,
and will take at least a few years. The
decision making of the Federal Reserve will face even more intense scrutiny in
the media considering the influence that its actions have over the markets for
bonds and stocks (see Caution - windy road ahead for explanation). The glare of the media will make it difficult
to keep the majority onside as even the much-revered former chairman of the
Federal Reserve, Alan Greenspan, discovered after falling from grace due to having
been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of
following behind the Federal Reserve.
The European Central Bank cut interest rates in May 2013 in a mainly
symbolic sign of its continued intentions to bolster the Eurozone where the
economy is expected to weaken by 0.3% in 2013 according to the IMF. The real possibility of a breakup of the
Eurozone was almost single-handily put to rest by the European Central Bank’s
willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left
the European Central Bank on red alert – everything is on hold in case another
crisis breaks out. The central bank in
Japan is heading in the opposite direction to its US counterpart and is ramping
up its monetary policy in the hope of kick-starting an economy which has been
stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of
us left trailing in the wake of their actions.
Not only will the direction of prices for stocks and bonds depend on
developments in monetary policy but gauging the suitable tempo of change by
central banks will be crucial in encouraging the nascent recovery in the global
economy. It may be the beginning of the
end in terms of central banks saving the world but there is still a long way to
go to get to safety.

2 comments:

A couple of articles on the future of bond buying at the Federal Reservehttp://money.cnn.com/2013/06/14/news/economy/federal-reserve-taper/index.htmlhttp://www.reuters.com/article/2013/05/29/us-investing-fed-quantitative-idUSBRE94S0K120130529And a couple more on forecasts for the global economyhttp://www.reuters.com/article/2013/05/29/us-oecd-idUSBRE94S0BH20130529http://www.ft.com/cms/s/0/03c36652-a66e-11e2-885b-00144feabdc0.html#axzz2WMzNG0SN